The Bank of England base interest rate has risen from 0.1% to 5% since December 2021 (see table below). Inflation, which remains high, is easily outpacing savings rates (see chart), a trend that is likely to continue for the second half of 2023. But what impact do high interest rates have on your finances, and what measures can you take to try and reduce the burden?
Interest rates hit a 15-year high
Official interest rates, which are set by the Bank of England and known as the ‘Bank Rate’, are at their highest point since 2008, in the wake of 13 consecutive hikes from 20 December 2021. The Bank Rate influences other interest rates, such as on savings accounts and for lending. This, with some lag, affects how much people spend and how much consumer items cost. By raising its interest rates, the central bank is aiming to bring price inflation back under control, in line with its long-term 2% target.
The shredding effect of inflation
Interest rates on savings accounts have climbed substantially over the past 18 months, but average rates are still well below the rate of CPI inflation, which remained unchanged at 8.7% in May, despite forecasts that it would fall. If inflation is greater than the interest rate or return earned on your savings and investments then your purchasing power in real terms is diminished. These ‘invisible’ losses can substantially erode your cash savings over time.
Savings vs. investments
Many savers are opting to pile money into savings accounts, in light of attractive interest rates. However, this is unlikely to be a long-term solution. Interest cash rates tend to be volatile historically, and saving accounts are unlikely to match the returns generated via an investment account (bearing in mind the ‘snowball effect’ of compounding returns) over a long-term horizon. Some savers are holding excessive amounts of cash in low-interest bank accounts, where the erosive effects of inflation are even more pronounced.
Investments have a greater chance of beating inflation over long-term horizons. Investing requires patience and discipline to ride out the ups and downs of markets. Investors often hold a mix of equities, bonds and other assets. This mix should be reviewed regularly in order to match changes in your risk tolerance and circumstances.
Overpaying on your mortgages vs. investments
Mortgage rates have rocketed in recent months, boosting the appeal of overpayments, subject to early repayment charges. Consider alternatives to paying money off your mortgage, such as topping up your pension and lowering your income tax bills. Investment returns after taxes and fees must exceed the mortgage costs over the long run, in order for this to be financially advantageous.
What’s going on with bonds?
Bonds are generally considered safer investments than stocks, but bond funds suffered heavy losses in 2022 as global interest rates rose. Losses of 10% on UK fixed income funds were not uncommon in the first few months of 2022, and in some cases losses have been double that. Some funds were more sheltered from this interest rate environment. Bond yields have, however, risen substantially in 2023, and certain bonds, alongside other fixed income investments, could form part of a balanced and well-diversified portfolio, depending on your investment goals and attitude to risk.
A well formulated plan with a corresponding investment strategy could provide the answers you are looking for amid a tough economic environment. Call 03300 564 446 to speak to a Lumin expert, or book a free introductory meeting via our contact form.
This article is for general information purposes only and does not constitute financial advice or a personal recommendation. Past performance is not a reliable indicator of future results. Investments can rise or fall in value, and you may receive less than you originally invested. Tax treatment depends on individual circumstances and may change in the future.
